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In Search of Funds That Don’t Rock the Boat

IN the canon of investing commandments, risk and return are inextricably linked. We’ve had it pounded into our heads that having a shot at higher returns requires accepting a more volatile portfolio. And any suggestion that it’s possible to ratchet down volatility without sacrificing performance would be an act of modern portfolio blasphemy, or a specious marketing ploy. Right?

Not exactly.

A study in The Journal of Portfolio Management reported that from 1968 through 2005, the least volatile stocks among a universe of the 1,000 largest issues had an annualized return that was nearly one percentage point more, on average, than the return of that universe, and had about 25 percent less volatility.

“We are not arguing that risk and return are not related,” says Harindra de Silva, co-author of the research paper and president of Analytic Investors. “What we are showing is that risk within an asset class is where low volatility comes into play.”

Another study, published last year in Financial Analysts Journal, looked at data from 1968 through 2008 and came to a similar conclusion. “When you look back over history, there isn’t a pattern of higher returns from higher-risk stocks,” says Malcolm Baker, a Harvard Business School finance professor and a co-author of that paper. The strategy is also effective in international stock markets, both developed and emerging.

The institutional investment firm Research Affiliates has done its own data analysis and found that over the long term, the low-volatility approach produced about a two-percentage-point advantage with 25 percent less volatility.

The low-volatility boomlet owes much to timing. Mr. de Silva of Analytic Investors and his colleagues published their research in 2006, and he says that when he discussed the strategy with institutional clients before 2008, “I usually heard a dial tone after three minutes.” But, he added, “there’s been a sea change since the financial crisis.”

That is no surprise, given that the strategy’s success resides in the fact that it outperforms in down markets.

In rolling 12-month periods from 1968 to 2005 when the market had a negative return, the lowest-volatility fifth of the Standard & Poor’s 500 lost an average of 9.3 percent, compared with a 14 percent loss for the overall index, according to Analytic Investors. Smaller drawdowns in bad times mean less ground to retrace when the market direction is up.

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But there is no magic bullet here. “You are going to lag and lag badly in bull markets,” notes Samuel Lee, a Morningstar analyst. Analytic Investors found that in strong bull markets, that lag is about three percentage points, on average. The Leuthold Group found a four-percentage-point average lag for low-volatility stocks in strong markets from 1990 to 2011.

That is largely because of the defensive stocks that dominate the bottom of the volatility charts. For example, the PowerShares S.& P. 500 Low Volatility E.T.F., which tracks the index of the 100 least volatile stocks in the S.& P. 500, had 29 percent invested in utility stocks at the end of September, more than seven times the sector’s weight in the benchmark 500 index.

The low-volatility strategy also shares plenty of DNA with value investing, which focuses on stocks trading at a price deemed below their fundamental value. Responding to client questions last year about the newly popular approach, Dimensional Fund Advisors concluded there was not much to the low-volatility strategy that was not already established in 1992 research by Eugene F. Fama and Kenneth R. French, showing that value is a distinct factor in explaining market returns.

“There is a lot of overlap in the two,” says Gerard O’Reilly, head of research at Dimensional Fund Advisors. The Fama-French research is a linchpin of the firm’s investment strategy, and both men serve on D.F.A.’s investment policy committee.

Indeed, Analytic Investors found that when controlled for both a value and a small-cap tilt, low-volatility stocks no longer had a return advantage, but there was still about 20 percent less volatility. “Low volatility is a separate factor from value,” says Charles M. Lahr, a global equity manager at Pimco. “Within value, you can have low- and high-volatility stocks, the crowning example being the financial sector.”

If low volatility is prized, it stands to reason that the strategy could be smothered to death by all the smart money piling in. But Mr. Baker of Harvard says, not so fast.

Of course, investors can have behavioral quirks, like the propensity to make lottery-type bets on long shots, that don’t jibe with the low-volatility strategy. Moreover, professional managers are typically judged and compensated by how well they track a given benchmark. By definition, the low-volatility strategy does not move in sync with standard index benchmarks. “Managers are not incentivized to take advantage of the low-volatility anomaly,” says Mr. Baker, a consultant to Acadian Asset Management, which manages low-volatility portfolios for clients.

INDIVIDUAL investors have no such constraint. Mr. Hsu of Research Affiliates says he would consider using the low-volatility strategy exclusively, given the advantageous risk-reward payoff over an entire market cycle. But Mr. de Silva notes that an all-in move requires a high level of tolerance for being different from the crowd.

“Theoretically you are much better off in low volatility,” he said, “but you have to ask yourself how you would feel when the market is up 40 percent and your low-volatility portfolio is up just 20 percent or 30 percent.”

A version of this article appears in print on October 7, 2012, on Page BU18 of the New York edition with the headline: In Search of Funds That Don’t Rock the Boat. Order Reprints|Today's Paper|Subscribe